Equity markets gained for the ninth week in ten, touching a fresh record high, as the wall of worry that has clouded markets for the past several years began to crumble. Just last week, we were given greater clarity on Fed policy, the China trade deal, Brexit, USMCA and a government shutdown. The resolution of some of these uncertainties should continue to refocus investor attention to a strong fundamental backdrop. Encouraging economic data suggest that recession fears are fading.
Last week’s optimism over a trade deal with China drew justifiable skepticism over the weekend. Both sides made announcements that a substantial “phase one” trade deal was agreed to last week, detailing Chinese purchases of U.S. goods and imposing protections on intellectual capital, while the U.S. would provide tariff relief. Chinese officials have been reticent to commit to specific agricultural purchases, and the two sides seem to differ on the schedule of tariff reductions. Additionally, the U.S. says that “phase two” discussions commence immediately, while Chinese officials say they will wait for implementation of the first phase. The goal is to sign the deal in the first week of January, though it will likely be done with negotiators, not Presidents Trump and Xi. Better-than-expected readings on industrial production and retail sales in China suggest that the trade war is having less of an impact than initially feared.
The FOMC, as expected, voted to keep interest rates unchanged, indicating a high threshold for changes in the near term. They are committed to growing the balance sheet sufficiently to stem year-end funding issues and disruption in the repo market. Inflation remains reasonably benign, with core CPI steady at 2.3% from a year ago and core producer price inflation down to 1.3%, the lowest early 2017. Chair Powell noted the lack of inflationary pressure as justification for the current rate policy. Given the market’s obsession on Fed policy over the past several years, acknowledgement that they are on the sidelines should be a positive for markets.
Brexit became a near certainty following a vote that delivered U.K. Conservatives their largest majority since 1987 and Labour having their worst showing since 1935. Prime Minister Johnson said that his government “has been given a powerful new mandate to get Brexit done.” Betting markets now show odds of a Brexit by February 1 at 85%, up from 55% a week ago. In a signal of the investor fatigue over the uncertainty surrounding Brexit, U.K. markets and the British pound both rallied on the news.
Global economic growth continues to be pressured, though improved clarity on trade and Brexit could stabilize confidence and support spending. Flash eurozone manufacturing PMI was a disappointing 45.9 (<50 suggests contraction) versus 46.9 in November, led by declines in Germany and France. Services PMI, however, were more encouraging. Both manufacturing and services PMI were below 50 in the U.K., pointing to political uncertainty. PMIs were also disappointing in Japan.
With fading exogenous fears, a strong domestic consumer and accommodative global central banks, the balance of risks seem to have shifted from the downside to the upside over the past several months. Investor confidence has bounced, Wall Street analysts are adjusting numbers higher and corporate executives are expressing greater optimism. Despite these factors and a near-30% return for the S&P 500 this year, investor behavior continues to reflect severe caution. This year, $315 billion has flowed out of equity mutual funds (-$186b including ETFs), with $283 billion ($417b including ETFs) into bond funds. A more normal allocation would result in a strong tailwind for equities.
What to Watch
A wave of economic data awaits this week, including PMI data on Monday, industrial production, housing starts and JOLTs job openings on Tuesday, leading indicators on Thursday, and revised 3Q GDP, consumer sentiment, personal income and expenses and PCE deflator on Friday. An impeachment vote is likely this week.
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